Opinion: Why the SEC’s crackdown could be good for initial coin offerings

LucasGeiger

Headlines this week that the Securities and Exchange Commission was cracking down on initial coin offerings (ICOs) may have, at first glance, read as very bad news for the cryptocurrency crowd, especially those issuing “tokens” to raise money to build blockchain-based projects.

ICOs, which issue tokens that are stored on a blockchain — akin to a global spreadsheet — have become an increasingly popular way to raise money for digital projects. This new and novel use of blockchain, a technology that also enables bitcoin and other cryptocurrencies, may sound mysterious. But those of us who use it know the blockchain is simply a decentralized database that can store transactions and values.

Some of the more popular ICOs this year raised hundreds of millions of dollars, capturing headlines and the imaginations of some who wondered if this could be a new form of venture capital.

The hype came to a halt on Tuesday, when the SEC declared that because certain species of ICO tokens were marketed with the promise of profits, they were behaving like securities. And so, the regulator said, they should be subject — depending “on the facts and circumstances” — to the rules that govern all securities.

Media reports described a new environment in which “unregistered offerings could be subject to criminal punishment.” These are some cold words for an overheated market!

Little cause for alarm

As a developer with an ICO scheduled for Sept. 1, you can imagine I read this news with some anxiety. But what I’ve come to see is that this development is more likely a good thing for the legitimate players in the blockchain and ICO ecosystem.

In fact, for some startups engaging in ICOs, there is little cause for alarm.

What it all comes down to is the Howey test, which is a longstanding mechanism used by the Supreme Court and the SEC to define whether an instrument is a security or not. The SEC specifically invoked the Howey test in Tuesday’s announcement. Further, the SEC indicated in its ruling that ethereum is a currency, for example, not a security.

The Howey test asks if an instrument represents: 1. the investment of money; 2. from an expectation of profits; 3. arising from a common enterprise; 4. depending solely on the efforts of a promoter or third party.

Ultimately, what caught the SEC’s interest was Dao (Distributed Autonomous Organization), a now-defunct blockchain venture capital fund that offered token-holders a voice in its management, and whose tokens were blatantly shares in the fund’s performance. The organization folded after it was the subject of a major hack, and while SEC officials said the agency wouldn’t pursue further action against Dao’s principals, they said it was an example of a project that demanded regulation.

If you are launching an ICO with a distribution of profit or revenues, or a guaranteed annuity, you are probably coloring way outside of the lines.

Private currency

But other ICOs issue tokens that do not behave this way at all. The SEC said that each one would need to be evaluated, using the Howey test as the benchmark. Some ICOs behave much more like a private currency.

Consider the example an arcade that sells tokens to patrons to play its video games. Those tokens have a use only for that arcade, and could even be bought and sold between patrons at the arcade, but we’d be hard-pressed to call them securities. Owning those tokens doesn’t give you an ownership interest or dividend from profits at the arcade.

That’s an approximation of the best use case for blockchain tokens. In the developer community I am building, using a token as the “unit of account” will be useful to streamline transactions between corporations and developers. This is an innovation that was not possible before blockchain, and it’s quite powerful. In fact, it might enable a platform to be built that would never happen without an ICO.

It could allow a status system in which a greater number of tokens could give a developer greater features and capabilities on the platform, such as free server time or the ability to edit others’ code. For a community building and sharing open source code, this kind of setup, and the funding up front from the ICO, could be transformational.

That’s the innovation of an ICO. You sell the underlying tokens for users of a system that enable you to create a vibrant ecosystem, bypassing years of ramp-up. In our arcade example, you’d sell tokens and use that money to buy all the best video games, and then people can come and play as much as they like with the tokens they’ve purchased.

No profit expectations

Cracking down on operations like DAO may clear up the speculation in the market and enable these kinds of legitimate token offerings to thrive.

These are ICOs that offer utility tokens that have no expectation of profit to outside buyers. That point may be getting lost in the noise of the speculative nature of this new market. There is no equity exchanged, no dividends and no special influence in the running of the company. Further, the intended customer of these tokens are often pretty sophisticated. In our case, it’s the developers and IT managers who will use the products, not investors or speculators.

To be sure, even in these legitimate ICOs, in theory the price of a token could fluctuate. But in practice, that should be no more inviting to speculators than airline miles, which do have fluctuating value as set by the airlines and the market. Those rewards miles are like crypto-tokens. They are transferrable and are sometimes even traded on third-party sites, but they are certainly not securities.

That the SEC is setting boundaries should not signal the death knell for ICOs, but rather it’s a sign that they are growing out of the infant stage into something more mature, where it can become an innovation that will be used by larger parts of society.

Lucas Geiger is the founder and CEO of Wireline, a marketplace for business applications. Wireline is raising the largest open-source developer fund through an ICO.

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